Figure 1. Overnight rates have turned more volatile with the introduction of term repos. Emphasis on term repos and limited overnight repos

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1 Flashnote Global Research Fixed Income Research Rates: Addressing money market volatility Receive 5yr INR OIS Money market volatility has increased as overnight repo borrowing is limited while the RBI places greater emphasis on term repos The central bank is likely to step in to stabilise overnight rates within a range of % Receive 5yr INR OIS in anticipation of liquidity-easing measures and receding inflation concerns André de Silva, CFA Head of Global EM Rates Research The Hongkong and Shanghai Banking Corporation Limited andre.de.silva@hsbc.com.hk Himanshu Malik Strategist The Hongkong and Shanghai Banking Corporation Limited himanshu1malik@hsbc.com.hk View HSBC Global Research at: Issuer of The Hongkong and Shanghai report: Banking Corporation Limited Disclaimer & Disclosures This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it OIS rates have risen sharply since the Reserve Bank of s (RBI) monetary policy meeting on 5 August. Market participants were expecting the RBI to introduce some liquidity-easing measures to reduce money market volatility (Figure 1). However, the central bank only reduced the Statutory Liquidity Ratio (SLR) and Held-to-Maturity (HTM) ceiling by 50bp each to 22% and 24%, respectively. While the SLR reduction has the potential to provide banks with additional liquidity worth INR430bn, this should not materialise unless banks choose to liquidate their Gsec holdings in excess of the SLR. As such, in order to stabilise the overnight fixing at around %, the RBI will likely have to introduce additional measures such as reducing the daily maintenance of the Cash Reserve Ratio or increase the amount of term repos. HSBC FI Research recommends receiving 5yr INR OIS rates to position for such measures, after rates have spiked by around 25bp over the past two weeks (entry: 8.23%, target: 8.0%, stop-loss: 8.35%). Concerns on food inflation are expected to ease as monsoon rains have picked up in recent weeks. According to s Meteorological Department, the rain deficit has narrowed to 18% of the Long Period Average from 25% two weeks ago. Inflation jumped from 7.46% y-o-y in June to 7.96% y-o-y in July on the back of rising food prices, but it is likely to stay below 8% y-o-y in the coming months, considering the high base effects of last year Figure 1. Overnight rates have turned more volatile with the introduction of term repos % RBI introduced measures in mid- July 2013 to tighten liquidity and curb FX speculation Apr-12 Aug-12 Jan-13 Jun-13 Oct-13 Mar-14 Aug-14 Overnight rate Emphasis on term repos and limited overnight repos Figure 2. Inflation likely to remain below 8% target %y-o-y Sep-12 Jan-13 Apr-13 Aug-13 Nov-13 Mar-14 Jun-14 CPI RBI's target CPI (Jan'15) RBI's target CPI (Jan'16)

2 (Figure 2). Furthermore, the RBI has recently shifted its focus from the consumer price inflation target of 8% by January 2015 to a long-term target of 6% by the end of Sub-8% consumer price inflation is likely to lead investors to price in monetary easing expectations. The decision to reduce the size of the Gsec auction on 14 August from INR140bn to only INR80bn underscores the government s surplus cash balance and the dividend transfer of INR527bn from the RBI to the government should have further increased the cash balance. The RBI may, therefore, choose to auction the surplus cash balance to commercial banks or back-load government bond borrowings to ease liquidity conditions. Evolution of a more credible monetary policy framework The risk premium in the INR yield curve should gradually decline with the evolution of an effective inflation-targeting framework. The Urjit Patel Committee recommended in January 2014 a new monetary policy framework to adopt consumer price inflation as the target of monetary policy. The recommendations, however, faced opposition from the previous government, which wanted the RBI to focus on both price stability and growth. Nevertheless, the new Finance Minister, Arun Jaitley, has recently indicated that the government agrees that the RBI should implement the new inflation-targeting framework. This should serve to reduce the ambiguity over monetary policy. The dual objectives of inflation and growth have, in the past, created policy uncertainty for investors as the central bank could switch to growth considerations at the expense of price stability. For instance, the RBI reduced the repo rate three times in the first half of 2013, even though inflation was running at double digits. Under the new policy framework, the RBI will have a clear policy objective of keeping inflation within the range of 2-6%, which compares with average inflation of 9.6% over the past two years. The inflation premium embedded in INR assets should fall with the implementation of the new policy framework. Smoothening the yield curve HSBC FI Research retains its preference for short-dated Gsecs (Long Gsec /19, entry: 8.45% on 30 July 2014, target: 8.25%). In recent statements, the RBI s Deputy Governor H.R. Khan has indicated that the central bank wants to smooth the yield curve, which is kinked at several points beyond the 6-year maturity (Figure 4). A reduction in the HTM ceiling should serve the same purpose, as there will be an increase in tradable bonds in the market. Alternatively, the central bank can also increase issuance in Figure 4. Yield curve is kinked at several pints Yield (%) Government securities Figure 5. Strong foreign demand for Gsecs Cuulative offshore investment (USDm) 10,000 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 0 Jan14 Feb14 Mar14 Apr14 May14 Jun14 Jul14 Foreign investment in dated Gsecs 2

3 tenors, which trade at premium to surrounding maturities. This was seen at the recent Gsecs auction, where the RBI increased the amount of 10-year Gsec sold to INR90bn versus the originally planned issuance of INR70bn while skipping the issuance in the year sector. In a bid to further smooth the yield curve, future issuance may continue to be skewed towards long-dated tenors. HSBC FI Research, therefore, prefers short-dated Gsecs, which would benefit from potential liquidity-easing measures and yet, remain unaffected by the RBI s change in bond issuance patterns. The supply-demand dynamics of Gsecs market are expected to remain favourable in the near term due to strong offshore investment demand. During the first four months of the fiscal year (April 2014 to July 2014), foreign investors have absorbed around 22% of the total bond issuance worth INR2.8trn. As such, the government has smoothly completed 48% of its full-year borrowing programme, which is estimated at INR5.97trn. There are bonds worth INR780bn or USD13bn scheduled to be sold before the end of September. Around 25% of this supply (USD3-4bn) should be absorbed by offshore investments after the latest USD5bn increase in the foreign investment debt quota. 3

4 Disclosure appendix Analyst Certification The following analyst(s), economist(s), and/or strategist(s) who is(are) primarily responsible for this report, certifies(y) that the opinion(s) on the subject security(ies) or issuer(s) and/or any other views or forecasts expressed herein accurately reflect their personal view(s) and that no part of their compensation was, is or will be directly or indirectly related to the specific recommendation(s) or views contained in this research report: Andre de Silva and Himanshu Malik Important Disclosures This document has been prepared and is being distributed by the Research Department of HSBC and is intended solely for the clients of HSBC and is not for publication to other persons, whether through the press or by other means. This document is for information purposes only and it should not be regarded as an offer to sell or as a solicitation of an offer to buy the securities or other investment products mentioned in it and/or to participate in any trading strategy. Advice in this document is general and should not be construed as personal advice, given it has been prepared without taking account of the objectives, financial situation or needs of any particular investor. Accordingly, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to their objectives, financial situation and needs. If necessary, seek professional investment and tax advice. Certain investment products mentioned in this document may not be eligible for sale in some states or countries, and they may not be suitable for all types of investors. Investors should consult with their HSBC representative regarding the suitability of the investment products mentioned in this document and take into account their specific investment objectives, financial situation or particular needs before making a commitment to purchase investment products. The value of and the income produced by the investment products mentioned in this document may fluctuate, so that an investor may get back less than originally invested. Certain high-volatility investments can be subject to sudden and large falls in value that could equal or exceed the amount invested. Value and income from investment products may be adversely affected by exchange rates, interest rates, or other factors. Past performance of a particular investment product is not indicative of future results. HSBC and its affiliates will from time to time sell to and buy from customers the securities/instruments (including derivatives) of companies covered in HSBC Research on a principal or agency basis. Analysts, economists, and strategists are paid in part by reference to the profitability of HSBC which includes investment banking revenues. Whether, or in what time frame, an update of this analysis will be published is not determined in advance. For disclosures in respect of any company mentioned in this report, please see the most recently published report on that company available at Additional disclosures 1 This report is dated as at. 2 All market data included in this report are dated as at close 12 August 2014, unless otherwise indicated in the report. 3 HSBC has procedures in place to identify and manage any potential conflicts of interest that arise in connection with its Research business. HSBC s analysts and its other staff who are involved in the preparation and dissemination of Research operate and have a management reporting line independent of HSBC s Investment Banking business. Information Barrier procedures are in place between the Investment Banking and Research businesses to ensure that any confidential and/or price sensitive information is handled in an appropriate manner. 4

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